Finding the right fund for a recent graduate

How to get a young investor started

Al in Federal Way, Wash., wants to get his grandson a graduation gift this month, and wants it to have a lasting impact.

He wanted to give the young man shares in a mutual fund.

“I want to start him young, give him something that can grow and show him what a help it is to start saving now,” Al said in an email. “I could just give $1,000 worth of shares in one of my funds, but I wondered if you had any thoughts on what would be the perfect mutual fund to give a graduate to get them started in investing.”

There is no “perfect” option, only sound choices that might turn out perfectly if life and the stock market break right for someone with decades of investing ahead of them.

But if you’re looking for a good fund to become the basis for a portfolio, you have a lot of items to choose from, and a bit of investor evaluation to do.

The basic decisions Al, and others like him, must make are:

Plant a new seed or use a trimming from his own tree?

Al suggested he might make the gift from his own portfolio. The obvious plus — aside from getting the tax benefit of giving shares that have appreciated in value since they were purchased — is that taking shares from your own portfolio allows the giver to say why the fund was chosen in the first place and to discuss the giver’s experience as an owner, passing along knowledge that the recipient can use.

The downside is that a fund that is right for Al, in his 70s, may not be right for the grandchildren.

Just like your grandkids don’t like the same music, they may not love the tune of a stodgy conservative fund when they have the time to take more chances and let them play out.

Active or passive?

Al can buy an index fund that represents the market, and emphasize the importance of ignoring ups and downs to capture the long-term trend. A total-market mutual fund or exchange-traded fund will do the trick, and can be a solid core holding for a lifetime, so that as his young investor matures and starts to build a portfolio, the first fund can remain an essential and appropriate part of the portfolio.

The flip side is to find a manager who his grandson can learn to trust, assuming the manager can deliver reasonable results in time. The problem here is that even the most staid, long-time manager doesn’t run a fund forever, and the young grandson at some point will have to live through a transition.

Using a manager who takes a quantitative approach — where the computer models are more important than the individual executing the marching orders — or finding a firm where a team approach has delivered consistent returns is a possibility.

The issue here, however, is which lesson you most want the new investor to learn. While capturing the market’s long-term trend with a core holding makes the most sense to me, if you fear that the market is due for any sort of short-run downturn, strapping your young graduate to the market for that ride could make them nauseous.

Of course, active managers have a lousy record when it comes to outperforming the market over time, so there’s the possibility the new investor will get frustrated seeing that play out.

With that in mind, if the choice is for active management, look for funds that typically outperform when the market is troubled, as that is the kind of issue a new investor is likely to be able to stick with.

Asset categories?

A first fund gives you an open slate. You can go with stocks, bonds or both, domestic, international or global, big companies or small stocks and more.

If your graduate has a particular interest — perhaps he’ll work in biotech or computers — you can even take the unusual step of starting with a specialized issue.

That said, some funds that seem like good first choices — balanced funds, or target-date issues that try to be one-for-a-lifetime — aren’t so great when young investors add funds and wants to control their investment mix.

Typically, however, first funds are core holdings, so err on the side of big, broad and diversified over hot, trendy or “interesting.”

Now or later?

A first fund is a step, but if life is going to force the investor to access the money soon, that changes the risk-reward part of the equation.

Obviously, Al is hoping to create a legacy, to jump-start a lifetime of investing interest, rather than to fund his grandson’s apartment furniture in a few weeks.

If your purchase is supposed to be the cornerstone for a lifetime of investment success, buy something that can stand the test of time. Pick a fund you believe the grandson will be proud to own when he gives a gift of shares to his own offspring, and you can’t go wrong.

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